Fed Model - Investment & Finance Definition

A
model that compares the returns from the 10-year Treasury note
and the Standard & Poor 500 to deter-
mine whether stocks are overvalued. The expected return from both instruments
should be roughly the same. The Treasury’s return, or its yield, is compared to
the stocks’ earnings yield, which is the expected earnings divided by price.
Rising stock prices that surpass expected earnings cause the earnings yield to
fall. If earnings fall below the 10-year Treasury yield, stocks are overvalued.
There is little incentive to buy potentially risky stocks if they don’t even
earn as much as risk-free Treasuries.

The Fed Model was constructed by Ed
Yardeni, the chief investment strategist at Prudential Securities as of this
printing. He constructed the model from comments made in a Federal Reserve
report to Congress in July 1997. The report included a paragraph that said the
yield on the 10-year Treasury note at that point far exceeded stocks’ earnings
yield.